Funding Education Through Equity

Earlier this week, the Oregon Legislature approved a plan that could pave the way for college students to finance their education by selling equity stakes in their future income. The idea is an intriguing one that has been bounced around before, but has never made it far in the United States, until now (a short stint by Yale in the 60s is the exception).

What makes it so appealing is that it is a glimmer of hope in the depressing enigma that is financing higher education. With both unsubsidized and subsidized Federal loan rates now at 6.8% (and Grad PLUS rates even higher), the student loan burden that comes with an undergraduate degree let alone further education can be daunting. Unfortunately, Federal loans are often the only option that a student has to pay for school nowadays.

Equity financing would allow these students to avoid debt in exchange for a portion of their future income for a set number of years. Proponents of the Oregon plan claim that 3% per year for 20 years would be enough to keep the program afloat. This is likely an optimistic scenario and there are almost certainly going to be additional hurdles to this sort of system working long-term, but this could be a step in the right direction. In the worst case scenario, it ends up being a decent natural experiment.

One of the primary concerns with this sort of program is financial sustainability for the investor- in this case the state of Oregon. Skeptics worry that students who expect to be high earners will not participate if it could mean they end up paying more in tuition when all is said and done. While what is currently on the table does not address this issue, a cap on repayment could help solve such a problem. The cap would still have to be higher than the average tuition rate charged by the school (in order for the program to remain independently sustainable), but could essentially be a way for students to trade the risks associated with uncertainty in future income for some extra money should things work out favorably.

Another issue is on the other end of the earning spectrum with those who might not make much upon graduation (or may not graduate at all). Adverse selection makes this problem especially worrisome. There is no difference for a student in terms of being eligible for this program whether he majors in a field with many jobs, no jobs, lucrative salaries, or low salaries. It is naturally attractive to those looking to study things that will not lead to large future incomes. Low incomes mean less money in, meaning the fund becomes harder to sustain.

Essentially, equity stakes and repayment years that are too low may attract too many borrowers who take out more than they put in, and equity stakes and repayment years that are too high may dissuade those who would put in enough to keep the program afloat. There may be a happy medium between the two, but there are also other options that could help increase the viability of equity funded education. Along with a cap on repayment, making part of the funding a mandatory loan could help strengthen the quality of borrowers. Attaching a loan could also help offset the cost hits from dropouts, etc. if they still have to may back the loan portion of the program. Varying the repayment rate or period based on major or performance could also help reduce costs and risk while also allowing the state to encourage certain degrees which might be in higher demand and have more desirable externalities. In the end, the state may end up having to cover losses associated with this sort of equity funding, but if the positive externality is great enough, it could even make it all worth it.

Overall, the Oregon proposal is far from perfect, but it is a start to something that could potentially be tweaked into a strong working model. It will be interesting to see how it works out.

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